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hormesis

To preview the conclusions briefly: in a country with poor long-run growth prospects – for example, because of unfavorable demographic trends – the short-term real interest rate that would be needed to match saving and investment may well be negative; since nominal interest rates cannot be negative, the country therefore “needs” expected inflation.

The theory here is that aggregate demand is being lowered by the (unproductive) hoarding of cash and treasuries. Therefore, the best way to get the economy flowing again is to make holding assets like cash and treasuries expensive, by creating inflation. This is what creates negative real rates — when the rate of inflation exceeds the rate of interest. Under such circumstances, hoarders should — in theory — draw down their Treasury and cash holdings and invest in more productive endeavours offering higher rates of return.

Negative real rates are a blunt axe used to bludgeon creditors including China who hold shedloads of cash and Treasuries. This could be a dangerous policy, because America is not energy-independent, and nor is it manufacturing-independent: it depends upon global oil, trade routes, and global manufacturing to function. That’s why America spends more than the rest of the world put together on its military. American agriculture is dependent on imported oil. American transportation is dependent on imported oil. Bludgeoning other powers — who have the power to upset the apple cart a little — could be seen as much like a game of Russian roulette.

The calculation could well be that China’s wealth is dependent on American stability — that interconnection has made the global system “too big to fail”. It is true that China is heavily invested in America — but assuming that that means America can thumb its nose at China’s interests seems naive. There are a lot of people in China desperate for a better standard of living. It would be naive to assume the Chinese government will forever carry the bag for America’s standard of living.

Paul Krugman believes that this would be good for America — that the transfer of dollars from West to East has effectively been a program of “quantitative diseasing”, and that if China liquidates she will effectively be conducting QE on behalf of the Fed, and thereby stimulating the American economy. Let’s flip that over: America — in continuing to buy Chinese goods and ship hoards of dollars to China — has been conducting “quantitative diseasing” of the dollar for most of the last 30 years. Maybe he’s right. But maybe not.

Forcing real rates even lower as a “policy tool” could be the spark that lights a bonfire, the straw that breaks the camel’s back. This denouement — that US Treasury debt is (in real-terms) a bad investment — could lead to all kinds of ramifications in the international financial system.

Possibly rather than moderating nominal debt values, or encouraging risk the inflationary road is a road to a trade war with America’s creditors, a trade war that a highly-dependent America — who controls neither her energy-intake nor her supply chains might struggle to win, even in the context of American military supremacy.